Are tyre makers driving towards a profit crest?

Tyre manufacturers are expected to show good pace of profit growth this fiscal, but there is reason to believe things will slow down in years ahead.

Over the past three years, the industry’s profitability has more than doubled, with earnings before interest, tax, depreciation and amortisation (Ebitda) margin surging from 7% in fiscal 2012 to 14.6% in fiscal 2015.

This was mainly because of a sharp reduction in prices of raw materials and a slight improvement in product mix (higher share of passenger vehicle tyres for replacement purposes). Correspondingly, return on capital employed (RoCE) rose to a healthy 24%, even as raw material cost as a percentage of revenue – the largest operating cost component – plummeted to a decadal low of 61% in fiscal 2015 after having touched 74.7% in 2012. Demand growth, though, remained subdued, weighing in at a paltry 3% compound annual growth rate over this period.

This fiscal, as per CRISIL Research estimates, Ebitda margin will rise as much as 400 basis points on-year to 18.5% – that’s nearly twice the decadal average of 9.6% – thanks to a sharp reduction in crude oil-based raw material cost and subdued natural rubber prices.

Prices of styrene butadiene rubber, polybutadiene rubber and carbon black are expected to decline 30%, 30% and 10% respectively, bringing about a 600 bps decline in raw material cost as a percentage of sales, though fixed costs such as employee and other operating expenses will remain high as utilisation levels come off and marketing spends rise.

Demand growth will increase to 6-8%, on improved freight availability and off-take by truck and bus and passenger vehicle OEMs.

However, going forward, profitability will come under pressure as pricing power of domestic players erodes due to a bevy of factors.

In the truck and bus radials segment, for instance, Chinese tyres are nearly 30% cheaper than domestic produce. While a pair of domestic radials is being sold at ~Rs 41,000, Chinese versions cost ~Rs 29,000

Capacity additions planned to tap the anticipated demand growth is one such factor. The investments, totaling more than Rs 100 billion, especially on radials in the truck, bus and passenger car segments, will push up supply and force manufacturers to reduce prices in the replacement market in a bid to maintain or gain market share. Additionally, large players such as Apollo and JK plan to enter the two-wheeler tyres segment, so competition will shoot up here, too.

Cheaper imports from China is also a problem area. The US, traditionally China’s largest market, imposed a heavy anti-dumping duty (up to 88%) on Chinese tyres for passenger cars and trucks in January last year. India, meanwhile, lifted anti-dumping duty on Chinese tyres in February 2015 on an appeal from tyre retailers, thereby opening the floodgates for radial tyres from China, especially in price-sensitive segments.

In the truck and bus radials segment, for instance, Chinese tyres are nearly 30% cheaper than domestic produce. While a pair of domestic radials is being sold at ~Rs 41,000, Chinese versions cost ~Rs 29,000.

Consequently, imports in this segment grew more than 70% year-on-year from the fourth quarter of fiscal 2015. In the second quarter of the current fiscal, imports accounted for 20-22% of domestic consumption.This could bring prices under pressure going forward, though manufacturers have managed to hold on so far. Players such as JK Tyres, which have stronger presence in the import-heavy truck and bus tyres segment, are likely to be particularly affected.

Other tyre segments could, however, remain insulated. With imports as a proportion of consumption lower than 10%, we don’t expect significant price correction in these segments till new capacities are commissioned.

As if this wasn’t enough, tailwinds from falling raw material prices are expected to reduce in the next 2-3 years if not dissipate altogether. We expect the prices of crude oil-based raw materials to decline marginally over the medium term -- compared with a sharp decline this fiscal –. Prices of natural rubber, on the other hand, are expected to bottom out as major exporting nations of the commodity such as Thailand, Indonesia and Malaysia take strong measures to reduce production and increase domestic consumption.

For example, Malaysia is planning to use 10% of total natural rubber production to construct roads to reduce excess supply. Thailand already uses 3.5 tonne of natural rubber for every 1 km of road.

We see industry Ebitda margin dropping as much as 250 bps in fiscal 2017 and more the following year. RoCE could decline by 100-200 bps, too.

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